Whether you’re a working professional, business owner, entrepreneur, or investor, knowing how to read and understand a cash flow statement can enable you to extract important data about the financial health of a company.
If you’re an investor, this information can help you better understand whether you should invest in a company. If you’re a business owner or entrepreneur, it can help you understand business performance and adjust key initiatives or strategies. If you’re a manager, it can help you more effectively manage budgets, oversee your team, and develop closer relationships with leadership—ultimately allowing you to play a larger role within your organization.
Not everyone has finance or accounting expertise. For non-finance professionals, understanding the concepts behind a cash flow statement and other financial documents can be challenging.
To facilitate this understanding, here’s everything you need to know about how to read and understand a cash flow statement.
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The purpose of a cash flow statement is to provide a detailed picture of what happened to a business’s cash during a specified period, known as the accounting period. It demonstrates an organization’s ability to operate in the short and long term, based on how much cash is flowing into and out of the business.
The cash flow statement is typically broken into three sections:
- Operating activities
- Investing activities
- Financing activities
Operating activities detail cash flow that’s generated once the company delivers its regular goods or services, and includes both revenue and expenses. Investing activities include cash flow from purchasing or selling assets—think physical property, such as real estate or vehicles, and non-physical property, like patents—using free cash, not debt. Financing activities detail cash flow from both debt and equity financing.
Based on the cash flow statement, you can see how much cash different types of activities generate, then make business decisions based on your analysis of financial statements.
Ideally, a company’s cash from operating income should routinely exceed its net income, because a positive cash flow speaks to a company’s ability to remain solvent and grow its operations.
It’s important to note that cash flow is different from profit, which is why a cash flow statement is often interpreted together with other financial documents, such as a balance sheet and income statement.
How Cash Flow Is Calculated
Now that you understand what comprises a cash flow statement and why it’s important for financial analysis, here’s a look at two common methods used to calculate and prepare the operating activities section of cash flow statements.
Cash Flow Statement Direct Method
The first method used to calculate the operation section is called the direct method, which is based on the transactional information that impacted cash during the period. To calculate the operation section using the direct method, take all cash collections from operating activities, and subtract all of the cash disbursem*nts from the operating activities.
Cash Flow Statement Indirect Method
The second way to prepare the operating section of the statement of cash flows is called the indirect method. This method depends on the accrual accounting method in which the accountant records revenues and expenses at times other than when cash was paid or received—meaning that these accrual entries and adjustments cause the cash flow from operating activities to differ from net income.
Instead of organizing transactional data like the direct method, the accountant starts with the net income number found from the income statement and makes adjustments to undo the impact of the accruals that were made during the period.
Essentially, the accountant will convert net income to actual cash flow by de-accruing it through a process of identifying any non-cash expenses for the period from the income statement. The most common and consistent of these are depreciation, the reduction in the value of an asset over time, and amortization, the spreading of payments over multiple periods.
Related: Financial Terminology: 20 Financial Terms to Know
How to Interpret a Cash Flow Statement
Whenever you review any financial statement, you should consider it from a business perspective. Financial documents are designed to provide insight into the financial health and status of an organization.
For example, cash flow statements can reveal what phase a business is in: whether it’s a rapidly growing startup or a mature and profitable company. It can also reveal whether a company is going through transition or in a state of decline.
Using this information, an investor might decide that a company with uneven cash flow is too risky to invest in; or they might decide that a company with positive cash flow is primed for growth. Similarly, a department head might look at a cash flow statement to understand how their particular department is contributing to the health and wellbeing of the company and use that insight to adjust their department’s activities. Cash flow might also impact internal decisions, such as budgeting, or the decision to hire (or fire) employees.
Cash flow is typically depicted as being positive (the business is taking in more cash than it’s expending) or negative (the business is spending more cash than it’s receiving).
Related: How Learning About Finance Can Jumpstart Your Career No Matter Your Industry
Positive Cash Flow
Positive cash flow indicates that a company has more money flowing into the business than out of it over a specified period. This is an ideal situation to be in because having an excess of cash allows the company to reinvest in itself and its shareholders, settle debt payments, and find new ways to grow the business.
Positive cash flow does not necessarily translate to profit, however. Your business can be profitable without being cash flow-positive, and you can have positive cash flow without actually making a profit.
Negative Cash Flow
Having negative cash flow means your cash outflow is higher than your cash inflow during a period, but it doesn’t necessarily mean profit is lost. Instead, negative cash flow may be caused by expenditure and income mismatch, which should be addressed as soon as possible.
Negative cash flow may also be caused by a company’s decision to expand the business and invest in future growth, so it’s important to analyze changes in cash flow from one period to another, which can indicate how a company is performing overall.
Cash Flow Statement Example
Here's an example of a cash flow statement generated by a fictional company, which shows the kind of information typically included and how it's organized.
![How to Read & Understand a Cash Flow Statement | HBS Online (1) How to Read & Understand a Cash Flow Statement | HBS Online (1)](https://i0.wp.com/online.hbs.edu/PublishingImages/FA_Statement_of_Cash_Flows_revised.jpg)
Go to the alternative version.
This cash flow statement shows Company A started the year with approximately $10.75 billion in cash and equivalents.
Cash flow is broken out into cash flow from operating activities, investing activities, and financing activities. The business brought in $53.66 billion through its regular operating activities. Meanwhile, it spent approximately $33.77 billion in investment activities, and a further $16.3 billion in financing activities, for a total cash outflow of $50.1 billion.
The result is the business ended the year with a positive cash flow of $3.5 billion, and total cash of $14.26 billion.
The Importance of Cash Flow
Cash flow statements are one of the most critical financial documents that an organization prepares, offering valuable insight into the health of the business. By learning how to read a cash flow statement and other financial documents, you can acquire the financial accounting skills needed to make smarter business and investment decisions, regardless of your position.
Are you interested in gaining a toolkit for making smart financial decisions and the confidence to clearly communicate those decisions to key internal and external stakeholders? Explore our online finance and accounting courses and download our free course flowchart to determine which best aligns with your goals.
Data Tables
Company A - Statement of Cash Flows (Alternative Version)
Year Ended September 28, 2019 (In millions)
Cash and cash equivalents, beginning of the year: $10,746
OPERATING ACTIVITIES
Activity | Amount |
---|---|
Net Income | 37,037 |
Adjustments to Reconcile Net Income to Cash Generated by Operating Activities: | |
Depreciation and Amortization | 6,757 |
Deferred Income Tax Expense | 1,141 |
Other | 2,253 |
Changes in Operating Assets and Liabilities: | |
Accounts Receivable, Net | (2,172) |
Inventories | (973) |
Vendor Non-Trade Receivables | 223 |
Other Current and Non-Current Assets | 1,080 |
Accounts Payable | 2,340 |
Deferred Revenue | 1,459 |
Other Current and Non-Current Liabilities | 4,521 |
Cash Generated by Operating Activities | 53,666 |
INVESTING ACTIVITIES
Activity | Amount |
---|---|
Purchases of Marketable Securities | (148,489) |
Proceeds from Maturities of Marketable Securities | 20,317 |
Proceeds from Sales of Marketable Securities | 104,130 |
Payments Made in Connection with Business Acquisitions, Net of Cash Acquired | (496) |
Payments for Acquisition of Intangible Assets | (911) |
Other | (160) |
Cash Used in Investing Activities | (33,774) |
FINANCING ACTIVITIES
Activity | Amount |
---|---|
Dividends and Dividend Equivalent Rights Paid | (10,564) |
Repurchase of Common Stock | (22,860) |
Proceeds from Issuance of Long-Term Debt, Net | 16,896 |
Other | 149 |
Cash Used in Financing Activities | (16,379) |
Increase / Decrease in Cash and Cash Equivalents: 3,513
Cash and Cash Equivalents, End of Year: $14,259
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As an expert in finance and accounting, I bring a wealth of knowledge and hands-on experience to the table. Having worked extensively in financial analysis and advising, I have a deep understanding of the intricacies involved in interpreting financial statements, particularly cash flow statements. My expertise is grounded in practical applications, where I've helped individuals and organizations navigate the complexities of financial documents to make informed decisions.
Now, delving into the concepts presented in the article, let's break down the key elements related to understanding a cash flow statement:
Cash Flow Statement Overview:
-
Purpose: A cash flow statement provides a comprehensive view of a business's cash movement during a specific period, demonstrating its ability to operate in both short and long terms.
-
Sections:
- Operating Activities: Involves cash generated from regular goods or services, covering revenue and expenses.
- Investing Activities: Encompasses cash flow from buying or selling assets, using free cash, not debt.
- Financing Activities: Details cash flow from both debt and equity financing.
How Cash Flow Is Calculated:
-
Direct Method:
- Process: Involves transactional information impacting cash during the period.
- Calculation: Subtract cash disbursem*nts from cash collections in operating activities.
-
Indirect Method:
- Process: Based on accrual accounting, starts with net income from the income statement and adjusts for accrual entries.
- Adjustments: Common adjustments include depreciation and amortization.
Interpreting a Cash Flow Statement:
-
Business Perspective: Financial documents, including cash flow statements, offer insights into the financial health and status of an organization.
-
Phases of a Business:
- Rapid Growth vs. Mature: Cash flow statements can indicate whether a business is rapidly growing or mature and profitable.
- Transition or Decline: They reveal if a company is undergoing transition or in a state of decline.
-
User Perspectives:
- Investors: Assess risk and growth potential.
- Business Owners/Entrepreneurs: Understand business performance and adjust strategies.
- Managers: Manage budgets, oversee teams, and contribute to organizational growth.
Positive vs. Negative Cash Flow:
-
Positive Cash Flow:
- Implications: More money flowing in than out.
- Benefits: Allows reinvestment, debt settlement, and business growth.
-
Negative Cash Flow:
- Causes: Could result from expenditure and income mismatch or deliberate investment for future growth.
- Analysis: Changes in cash flow from period to period indicate overall company performance.
Cash Flow Statement Example (Company A):
- Components: Starting cash, operating activities, investing activities, financing activities, and ending cash.
- Insights: Positive cash flow of $3.5 billion indicates a healthy financial position.
The Importance of Cash Flow:
- Critical Document: Cash flow statements are crucial for understanding the financial health of a business.
- Decision-Making: Reading and understanding financial statements empower individuals to make informed business and investment decisions.
By grasping these concepts, individuals can enhance their financial literacy and make strategic decisions, whether they are investors, business owners, or managers. If you're looking to deepen your understanding further, exploring finance and accounting courses can be a valuable next step.